The Two Main Carbon Pricing Instruments
There are two primary ways to put a price on carbon emissions: carbon taxes and emissions trading systems. Both achieve the same goal (making pollution costly), but they work in fundamentally different ways.
Understanding these differences is crucial for anyone involved in climate policy, whether you are a policymaker choosing an instrument, a business preparing for compliance, or a citizen trying to understand the debate.
Carbon Tax: The Government Sets the Price
A carbon tax works exactly like it sounds. The government sets a price per ton of CO2 (or CO2 equivalent for other greenhouse gases), and anyone who emits must pay that price.
With a carbon tax, the government controls the price of emissions. The quantity of emissions that results depends on how businesses and consumers respond to that price.
How it works in practice:
- The government sets a tax rate (for example, $30 per ton of CO2)
- Fuel suppliers, power plants, or other regulated entities report their emissions
- They pay the tax based on their emissions
- The tax revenue goes to the government
Example: A power plant burns coal and emits 1 million tons of CO2 per year. At a carbon tax rate of $30/ton, it owes $30 million annually. To reduce this bill, the plant might switch to natural gas (lower emissions per unit of energy), add emissions controls, or invest in renewable energy.
Emissions Trading System: The Government Sets the Quantity
An emissions trading system (ETS), also called cap-and-trade, flips the approach. Instead of setting the price, the government sets a limit (cap) on total emissions and issues permits (allowances) up to that limit.
With an ETS, the government controls the quantity of emissions. The price emerges from trading in the market, based on supply and demand for allowances.
How it works in practice:
- The government sets a cap on total emissions (for example, 100 million tons of CO2)
- It creates allowances equal to the cap (100 million allowances, each worth 1 ton)
- It distributes allowances to regulated entities (through auctions or free allocation)
- At the end of each compliance period, entities must surrender allowances equal to their emissions
- Entities that emit less than their allowances can sell the surplus; those that emit more must buy
Example: A country caps power sector emissions at 100 million tons and gives each plant allowances based on historical emissions. Plant A receives 10 million allowances but only emits 8 million tons. Plant B receives 10 million allowances but emits 12 million tons. Plant A can sell 2 million allowances to Plant B. Both end up with allowances matching their emissions.
Price Certainty vs Quantity Certainty
The fundamental trade-off between these instruments is whether you want certainty over the carbon price or certainty over the emissions quantity.
| Feature | Carbon Tax | Emissions Trading System |
|---|---|---|
| What government controls | Price per ton | Total quantity of emissions |
| What is uncertain | How much emissions will fall | What price will emerge |
| Price stability | High (government sets rate) | Lower (market determines price) |
| Emissions certainty | Lower (depends on response) | High (cap is fixed) |
| Revenue predictability | High | Depends on allowance distribution method |
Think of it like controlling traffic on a bridge. A carbon tax is like setting a toll: you know the price, but you cannot be sure how many cars will cross. An ETS is like limiting the number of cars: you know the quantity, but the value of a crossing permit will vary based on demand.
When Might You Prefer a Carbon Tax?
Carbon taxes tend to work well when:
1. Price stability matters for investment
Businesses making long-term investments need to know what carbon will cost in 5, 10, or 20 years. A carbon tax with a pre-announced trajectory (for example, starting at $20 and rising $5 per year) provides this clarity.
2. Administrative capacity is limited
Carbon taxes are simpler to implement. They can often piggyback on existing fuel tax infrastructure. You do not need to create a new trading market or track individual transactions.
3. The regulated sector has few large emitters
Trading works best with many participants. If a sector has only a handful of companies, a carbon tax avoids the risk of market manipulation.
When Might You Prefer an ETS?
Emissions trading systems tend to work well when:
1. Hitting an emissions target is the priority
If a country has committed to specific emissions reductions (say, under the Paris Agreement), an ETS guarantees that covered emissions will not exceed the cap.
2. Cost-efficiency across different actors matters
Trading allows emissions reductions to flow to wherever they are cheapest. A power company with expensive abatement options can buy allowances from a factory with cheap options, lowering total costs.
3. There are many diverse emitters
A liquid market requires many buyers and sellers. The EU ETS, with thousands of installations, supports an active secondary market.
4. International linking is a goal
ETSs can be linked across jurisdictions more easily than carbon taxes, allowing for broader markets and more cost-effective reductions.
Hybrid Approaches: Getting the Best of Both
In practice, the line between carbon taxes and ETSs has blurred. Many systems incorporate elements of both:
Price floors and ceilings in ETSs
Some ETSs set minimum and maximum prices for allowances. California's cap-and-trade program, for example, has both a price floor (allowances cannot sell below a certain price) and a price ceiling (if prices rise too high, additional allowances become available).
Tax rate adjustments based on emissions
Some carbon taxes adjust their rates based on whether emissions targets are being met, introducing an element of quantity control.
Mexico provides an interesting example of using both carbon pricing instruments. In 2014, the country introduced a carbon tax on fossil fuels (excluding natural gas) as part of a broader fiscal reform. The tax rate started low, around $3 per ton of CO2.
Then in 2020, Mexico launched a pilot ETS covering large industrial emitters and power generators. The two systems cover different parts of the economy and serve different purposes:
- The carbon tax provides broad coverage and immediate revenue
- The ETS creates a market-based mechanism for large emitters and builds capacity for future ambition
This approach allows Mexico to gain experience with both instruments while expanding carbon pricing coverage over time.
Crediting Mechanisms: A Third Option
Beyond taxes and trading systems, there is a third carbon pricing approach: crediting mechanisms. These do not cap emissions or set a tax rate. Instead, they create demand for verified emission reductions.
Under a crediting mechanism:
- A project developer implements an activity that reduces emissions (like building a wind farm or protecting a forest)
- An independent body verifies the emission reductions
- The project receives carbon credits for each ton of CO2 avoided or removed
- These credits can be sold to companies that want to offset their own emissions
Credits do not directly price emissions from regulated entities. Instead, they create a positive incentive for emission reduction activities. Many carbon taxes and ETSs allow credits to be used for compliance, linking the systems together.
Carbon taxes set the price. ETSs set the quantity. Credits create demand for verified reductions. All three can work together in a comprehensive carbon pricing system.
Making the Choice
There is no universally "better" instrument. The right choice depends on:
- Your jurisdiction's policy objectives
- Your administrative and institutional capacity
- Your economic structure and emissions profile
- Your political context and stakeholder preferences
We will explore these decision factors in detail in Module 6. For now, the key takeaway is that both carbon taxes and ETSs can be effective. The design details matter more than the choice of instrument.
Looking Ahead
In the next lesson, we will examine how carbon pricing fits within the broader climate policy mix and how it interacts with other policies like renewable energy mandates and efficiency standards.